Exploring the Fixed-Charge Coverage Ratio: Meaning, Calculation, and Real-life Scenarios
The Fixed-Charge Coverage Ratio (FCCR) is a key financial metric that provides insight into a company's ability to meet its fixed financial obligations, such as interest payments, lease payments, and principal repayments, using its earnings before interest and taxes (EBIT) or adjusted EBITDA.
Calculation and Interpretation
The FCCR is calculated by dividing EBIT or Adjusted EBITDA by the total fixed charges (interest expense, lease payments, and principal debt repayments). A higher FCCR indicates better financial stability and creditworthiness, as it shows that the company comfortably generates enough operating income to manage these fixed charges without distress.
An FCCR above 2.0 is generally considered strong, especially in capital-intensive industries, meaning the company earns at least twice its fixed charges, implying good operational efficiency and financial discipline. Values below 1.0 indicate insufficient earnings to cover fixed charges, signaling high risk of default or financial distress. Fluctuations and trends in FCCR over time help assess whether creditworthiness is improving or deteriorating.
Use by Lenders and Investors
Lenders rely on FCCR to decide loan amounts and terms, as it shows the risk of lending to the company. Investors use it to gauge the financial health and long-term sustainability of a business before investing.
However, it's important to note that the FCCR does not take into account rapid changes in the amount of capital for new and growing companies. It also does not consider the effects of funds taken out of earnings to pay an owner's draw or pay dividends to investors.
When banks evaluate a company's creditworthiness, they typically look at several other benchmarks in addition to the FCCR. Both omissions can give a misleading conclusion unless other metrics are also considered.
In summary, a higher Fixed-Charge Coverage Ratio means better ability to cover required fixed payments, indicating greater financial stability and creditworthiness, while a low ratio signals risk in meeting financial obligations. It is a critical metric for lenders, investors, and credit rating agencies in evaluating a firm's capacity to sustain fixed financial commitments.
[1] Investopedia. (2021). Fixed-Charge Coverage Ratio. [online] Available at: https://www.investopedia.com/terms/f/fixedchargecoverageratio.asp
[2] Investopedia. (2021). Interest Coverage Ratio. [online] Available at: https://www.investopedia.com/terms/i/interestcoverageratio.asp
[3] Investopedia. (2021). EBIT. [online] Available at: https://www.investopedia.com/terms/e/ebit.asp
[4] Investopedia. (2021). Adjusted EBITDA. [online] Available at: https://www.investopedia.com/terms/a/adjustedebitda.asp
[5] Investopedia. (2021). Fixed Charges. [online] Available at: https://www.investopedia.com/terms/f/fixedcharges.asp
[1] In the realm of personal-finance and wealth-management, understanding the Fixed-Charge Coverage Ratio (FCCR) can be valuable for business owners when making decisions about investing or securing financing for mining ventures or other projects.
[2] Moreover, Initial Coin Offerings (ICOs) may attract investors who weigh the financial health of the business behind the ICO, and a high FCCR could potentially highlight a company's financial stability, making it a more attractive investment target.
[3] Furthermore, financial advisors in the wealth-management industry might recommend companies with strong FCCRs to their clients, as they are less likely to face financial distress or default, offering a more secure option for both short-term and long-term investment strategies.
